Financial Management Accounting The Dilemma at Day-Pro Class Case #5 November 10, 2018
Submitted to: Felix D. Cena, CPA, PhD
Submitted by: Feria, Hanah
Saturday, 2:00PM – 5:00 PM
1. Calculate the Payback Period of each project. Explain what argument Mike should make to show that the Payback Period is not appropriate in this case.
SYNTHETIC RESIN
EPOXY RESIN
Year
Cash Flow
Cumulative CF
Year
Cash Flow
Cumulative CF
0
(1,000,000.00)
(1,000,000.00)
0
(800,000.00)
(800,000.00)
1
350,000.00
(650,000.00)
1
600,000.00
(200,000.00)
2
400,000.00
(250,000.00)
2
400,000.00
200,000.00
3
500,000.00
250,000.00
3
300,000.00
500,000.00
4
650,000.00
900,000.00
4
200,000.00
700,000.00
5
700,000.00
1,600,000.00
5
200,000.00
900,000.00
SYNTHETIC RESIN
EPOXY RESIN
Cash Flow
Payback Period
=
n
+
Payback Period
=
2
+
Payback Period
=
2
+
Payback Period
=
Cash Flow
Payback Period
=
n
+
Payback Period
=
1
+
0.5
Payback Period
=
1
+
2.5 years
Payback Period
=
Cumulative Cash Flow 250,000.00 500,000.00
Cumulative Cash Flow 200,000.00 400,000.00 0.5 1.5 years
The payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions. Epoxy Resin project has a payback period of 1.5 years while Synthetic Resin has a longer payback period of 2.5 years. On the basis of this methodology we will choose to invest in Epoxy Resin. As the 2 projects have different initial investment, it’s not appropriate to use the payback period method. The smaller the amount, the faster the recovery. Also, it cannot measure the whole investor’s wealth for it is only focusing on the time the initial cost of capital was recovered.
2. Calculate the Discounted Payback Period (DPP) using 10% as the discount rate. Should Mike ask the Board to use DPP as the deciding factor? Explain. SYNTHETIC RESIN
PV of Cash Flow
EPOXY RESIN
Year
Cash Flow
0
(1,000,000.00)
Cumulative CF
Year
Cash Flow
(1,000,000.00)
0
(800,000.00)
PV of Cash Flow
1
350,000.00
2
400,000.00
3
500,000.00
375,657.40
24,417.73
3
300,000.00
225,394.44
301,427.50
4
650,000.00
443,958.75
468,376.48
4
200,000.00
136,602.69
438,030.19
5
700,000.00
434,644.93
903,021.40
5
200,000.00
124,184.26
562,214.45
318,181.82
(681,818.18)
1
600,000.00
545,454.55
(254,545.45)
330,578.51
(351,239.67)
2
400,000.00
330,578.51
76,033.06
(800,000.00)
SYNTHETIC RESIN
Discounted Payback Period Discounted Payback Period
= =
Discounted Payback Period
=
Discounted Payback Period
=
n 2 2
+ + +
Cumulative CF
EPOXY RESIN
Cash Flow Cumulative Cash Flow 351,239.67 375,657.40 0.935 2.94 years
Discounted Payback Period
=
n
+
Discounted Payback Period
=
1
+
Discounted Payback Period
=
1
+
Discounted Payback Period
=
Cash Flow Cumulative Cash Flow 254,545.45 330,578.51 0.77 1.77 years
The discounted payback period is a capital budgeting procedure used to determine the profitability of a project. A discounted payback period gives the number of years it takes t o break even from undertaking the initial expenditure, by discounting future cash flows and recognizing the time value of money. Based on t he computations above, Epoxy Resin is the most viable project. It is vital for Tim t o weigh the cost and the benefits of the two proposals and the payback methods cannot simply do this to an extent in which it can maximize the company's wealth.
3. If management prefers to have a 40% accounting rate of return, which project would be accepted? What is wrong with this decision? SYNTHETIC RESIN
EAT
=
EAT
=
EAT
=
ARR
=
ARR
=
ARR
=
EPOXY RESIN
Last Cumulative Cash Flow n 1,600,000.00 5 320,000.00 EAT Ave. Investment 320,000.00 500,000.00 64.00%
EAT
=
EAT
=
EAT
=
ARR
=
ARR
=
ARR
=
Last Cumulative Cash Flow n 700,000.00 5 140,000.00 EAT Ave. Investment 140,000.00 400,000.00 35.00%
ARR for Synthetic Resin is 64% and 45% for Epoxy Resin. Since the acceptable ARR for both projects is 40% it may be difficult for Tim to make the right decision as both will be generating wealth. Also, ARR does not consider the time value of money or cash flows, which can be an integral part of maintaining the business.
4. Calculate the two projects’ IRR. How should Mike convince the Board that the IRR measure could be misleading? SYNTHETIC RESIN
Year
Cash Flow
Discounted 10%
PV Factor @ 30%
PV @ 30%
PV Factor @ 40%
PV @ 40%
1
350,000.00
318,181.82
0.769
269,230.77
0.714
250,000.000
2
400,000.00
330,578.51
0.592
236,686.39
0.510
204,081.633
3
500,000.00
375,657.40
0.455
227,583.07
0.364
182,215.743
4
650,000.00
443,958.75
0.350
227,583.07
0.260
169,200.333
5
700,000.00
434,644.93
0.269
188,530.35
0.186
130,154.102
Cash Inflow
1,903,021.40
1,149,613.65
935,651.81
Cash Outflow
1,000,000.00
1,000,000.00
1,000,000.00
NPV
903,021.40
149,613.65
(64,348.19)
SYNTHETIC RESIN
IRR
=
discount rate
+
(
IRR
=
10%
+
(
IRR
=
10%
+
(
IRR
=
10%
+
(
IRR
=
10%
+
IRR
=
discounted NPV discounted NPV
-
present value
903,021.40 903,021.40
-
(64,348.19)
903,021.40 967,369.59 0.93 28% 38.00%
)
(
PV rate
-
discount rate
)
)
(
40%
-
10%
)
)
(
30%
)
)
(
30%
)
EPOXY RESIN
Year
Cash Flow
Discounted 10%
PV Factor @ 40%
PV @ 40%
PV Factor @ 45%
PV @ 45%
1
600,000.00
545,454.55
0.714
428,571.43
0.690
413,793.103
2
400,000.00
330,578.51
0.510
204,081.63
0.476
190,249.703
3
300,000.00
225,394.44
0.364
109,329.45
0.328
98,405.019
4
200,000.00
136,602.69
0.260
52,061.64
0.226
45,243.687
5
200,000.00
124,184.26
0.186
37,186.89
0.156
31,202.543
Cash Inflow
1,362,214.45
831,231.03
778,894.05
Cash Outflow
800,000.00
800,000.00
800,000.00
NPV
562,214.45
31,231.03
(21,105.95)
IRR
=
discount rate
+
(
IRR
=
10%
+
(
IRR
=
10%
+
(
IRR
=
10%
+
(
IRR
=
10%
+
IRR
=
discounted NPV discounted NPV
-
present value
562,214.45 562,214.45
-
(21,105.95)
562,214.45 583,320.40 0.96
)
(
PV rate
-
discount rate
)
)
(
45%
-
10%
)
)
(
35%
)
)
(
35%
)
34% 43.73%
The IRR for Synthetic project is 38%, and the Epoxy project is 43.73%. The NVP for Synthetic project is 903,021.40, and the Epoxy project is 562,214.45, so even though Synthetic project has a lower IRR than Epoxy Resin project, NPV contradicts this and thus we must analyze this even further. IRR is not equal to annual rate of return. Assumptions of IRR are not always reasonable and rational. IRR itself may produce misleading results.
5.
Calculate the NPV profiles for the two projects and explain the relev ance of the crossover point. How should Mike convince the Board that the NPV method is the way to go? SYNTHETIC RESIN
Year
Cash Flow
1
350,000.00
2
400,000.00
3
500,000.00
4
650,000.00
5
700,000.00
EPOXY RESIN
NPV 350,000.00 (1+ 10%)1 400,000.00 (1+ 10%)
2
500,000.00 (1+ 10%)
3
650,000.00 (1+ 10%)
4
700,000.00 (1+ 10%)5
Year
Cash Flow
318,181.82
1
600,000.00
330,578.51
2
400,000.00
375,657.40
3
300,000.00
443,958.75
4
200,000.00
434,644.93
5
200,000.00
NPV 600,000.00
545,454.55
(1+ 10%)1 400,000.00
330,578.51
(1+ 10%)2 300,000.00
225,394.44
(1+ 10%)3 200,000.00
136,602.69
(1+ 10%)4 200,000.00
124,184.26
(1+ 10%)5
Total NPV
1,903,021.40
Total NPV
1,362,214.45
Investment
(1,000,000.00)
Investment
(800,000.00)
NPV
903,021.40
NPV
562,214.45
Year
Synthetic Resin
Epoxy Resin
Difference
0
(1,000,000.00)
(800,000.00)
(200,000.00)
1
350,000.00
600,000.00
(250,000.00)
2
400,000.00
400,000.00
-
3
500,000.00
300,000.00
200,000.00
4
650,000.00
200,000.00
450,000.00
5
700,000.00
200,000.00
500,000.00
IRR
38.00%
43.73%
29.17%
NPV
903,021.40
562,214.45
Crossover Point 1,600,000.00 1,400,000.00 1,200,000.00 1,000,000.00 800,000.00 600,000.00 400,000.00 200,000.00 (200,000.00)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46
(400,000.00) NPV Synthetic
NPV Epoxy
Discount Rate
NPV Synthetic
NPV Epoxy
Difference
Discount Rate
NPV Synthetic
NPV Epoxy
Difference
1%
1,514,611.35
859,844.08
654,767.28
24%
318,355.63
254,179.10
64,176.54
2%
1,433,277.03
821,314.75
611,962.27
25%
287,616.00
237,056.00
50,560.00
3%
1,355,757.75
784,324.30
571,433.45
26%
257,988.56
220,441.39
37,547.17
4%
1,281,830.82
748,790.73
533,040.10
27%
229,421.89
204,314.41
25,107.48
5%
1,211,288.85
714,637.37
496,651.48
28%
201,867.39
188,655.24
13,212.15
6%
1,143,938.50
681,792.46
462,146.03
29%
175,279.12
173,445.08
1,834.04
7%
1,079,599.45
650,188.80
429,410.65
29%
170,852.05
170,902.71
(50.66)
8%
1,018,103.36
619,763.37
398,340.00
30%
149,613.65
158,666.07
(9,052.42)
9%
959,293.01
590,457.08
368,835.94
31%
124,829.84
144,301.22
(19,471.38)
10%
903,021.40
562,214.45
340,806.95
32%
100,888.78
130,334.40
(29,445.62)
11%
849,151.04
534,983.39
314,167.65
33%
77,753.59
116,750.25
(38,996.66)
12%
797,553.22
508,714.90
288,838.33
34%
55,389.32
103,534.14
(48,144.82)
13%
748,107.40
483,362.91
264,744.49
35%
33,762.85
90,672.16
(56,909.31)
14%
700,700.56
458,884.04
241,816.51
36%
12,842.75
78,151.04
(65,308.29)
15%
655,226.73
435,237.46
219,989.27
37%
(7,400.79)
65,958.15
(73,358.94)
16%
611,586.46
412,384.66
199,201.80
38%
(26,996.09)
54,081.43
(81,077.52)
17%
569,686.34
390,289.34
179,397.00
39%
(45,970.04)
42,509.38
(88,479.42)
18%
529,438.60
368,917.23
160,521.37
40%
(64,348.19)
31,231.03
(95,579.22)
19%
490,760.73
348,235.98
142,524.75
41%
(82,154.82)
20,235.91
(102,390.74)
20%
453,575.10
328,215.02
125,360.08
42%
(99,413.04)
9,514.01
(108,927.05)
21%
417,808.65
308,825.46
108,983.18
43%
(116,144.83)
(944.24)
(115,200.58)
22%
383,392.53
290,039.97
93,352.56
44%
(132,371.09)
(11,147.98)
(121,223.11)
23%
350,261.91
271,832.68
78,429.23
45%
(148,111.74)
(21,105.95)
(127,005.80)
Crossover rate is the cost of capital at which the net present values of two projects are equal. It is the point at which the NPV profile of one project crosses over (intersects) the NPV profile of the other project. Crossover rate is useful in capital budgeting analysis because it tells the investing company about the cost of capital at which both of the mutually-exclusive projects are equally good. If the company's cost of capital crosses the crossover rate, the relative attractiveness of mutually-exclusive projects changes. For example, if Synthetic Resin is preferable at a discount rate below the crossover rate, Epoxy Resin becomes feasible as soon a s the cost of capital crosses the crossover rate.
Mike should tell the board that NPV is the best method to use to decide between Synthetic and Epoxy Resins. NPV is the single best criterion because it provides a direct measure of the value the projects adds to the shareholders’ we alth. Also, it accounts the time value of money and can be used to compare investment alternatives that are similar. The NPV relies on a discount rate of return that may be derived from the cost of the capital required to make the investment, and any project or investment with a negative NPV should be avoided.
6.
Explain how Mike can show that the Modified Internal Rate of Return is the more realistic measure to use in the case of manually exclusive projects.
SYNTHETIC RESIN
Year
Cash Flow
FV Factor
FV
0
(1,000,000.00)
1
350,000.00
1.464
512,435.000
2
400,000.00
1.331
532,400.000
3
500,000.00
1.210
605,000.000
4
650,000.00
1.100
715,000.000
5
700,000.00
MIRR
MIRR
=
=
(
(
FV of Cash Flows PV of Cash Flows 3,064,835.000 1,000,000.000
( ) ( )
700,000.000 3,064,835.000
MIRR
=
MIRR
=
MIRR
=
( (
3.065
)
(
3.065
)
1 n 1 5
0.2
) -1 ) -1 ) -1
0.2
25.11%
-1
EPOXY RESIN
Year
Cash Flow
FV Factor
FV
0
(800,000.00)
1
600,000.00
1.464
878,460.000
2
400,000.00
1.331
532,400.000
3
300,000.00
1.210
363,000.000
4
200,000.00
1.100
220,000.000
5
200,000.00
MIRR
MIRR
=
=
(
(
FV of Cash Flows PV of Cash Flows 2,193,860.000 800,000.000
( ) ( )
200,000.000 2,193,860.000
MIRR
=
MIRR
=
MIRR
=
( (
2.742
1 n 1 5
0.2
)
) -1 ) -1 ) -1
0.2 (
2.742
)
-1
22.36%
Mutually exclusive projects refer to a sect of projects out of which only one project can be selected for investment. MIRR is predominantly more accurate for these kind of projects. Modified internal rate of return (MIRR) assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. By contrast, the traditional internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR. The MIRR more accurately reflects the cost and profitability of a project. Since Synthetic Resin and Epoxy Resin are projects of unequal size, the MIRR is best used to rank investments or projects. The calculation is a solution to two major problems that exist with the popular IRR calculation. The first main problem with IRR is that multiple solutions can be found for the same project. The second problem is that the assumption that positive cash flows are reinvested at the IRR is considered impractical in practice. With the MIRR, only a single solution exists for a given project, and reinvestment rate of positive cash flows is much more valid in practice. Assuming that we used the 10% rate still if the cash flows will be deposited at the bank, Synthetic’s MIRR is 25.11% and Epoxy’s is 22.36%. Given the rates, Mike should consider also the total
amount of return in the project and the return rate of the re-investment.
7. Calculate the Profitability Index for each proposal. Can this measure help to solve the dilemma? Explain. SYNTHETIC RESIN
Year
Cash Flow
0
(1,000,000.00)
PV of Cash Flow
1
350,000.00
2 3
EPOXY RESIN
Cumulative CF
Year
Cash Flow
PV of Cash Flow
Cumulative CF
(1,000,000.00)
0
(800,000.00)
318,181.82
(681,818.18)
1
600,000.00
400,000.00
330,578.51
(351,239.67)
2
400,000.00
330,578.51
76,033.06
500,000.00
375,657.40
24,417.73
3
300,000.00
225,394.44
301,427.50
4
650,000.00
443,958.75
468,376.48
4
200,000.00
136,602.69
438,030.19
5
700,000.00
434,644.93
903,021.40
5
200,000.00
124,184.26
562,214.45
545,454.55
1,903,021.40
=
Profitability Index
=
Profitability Index
=
(254,545.45)
1,362,214.45
SYNTHETIC RESIN
Profitability Index
(800,000.00)
EPOXY RESIN
PV of Future Cash Flows Investment 1,903,021.40 1,000,000.00 1.90
Profitability Index
=
Profitability Index
=
Profitability Index
=
PV of Future Cash Flows Investment 1,362,214.45 800,000.00 1.70
A profitability index attempts to identify the relationship between the costs and benefits of a proposed project. A PI greater than 1.0 indicates that profitability is positive, while a PI of less than 1.0 indicates that the project will lose money. As values on the profitability index increase, so does the financial attractiveness of the proposed project. As both projects have a PI greater than 1, this does not help solve the dilemma.
8. In looking over the documentation prepared by the two project teams, it appears to you that the Synthetic Resin team has been somewhat more conservative in its revenue projections than the Epoxy Resin team. What impact might this have on your analysis? Cash flow changes during the initial periods of the project is very critical in using the NPV. A higher cash flow in the opening periods with a low discount rate leads to a higher NPV. If we use the previous NPV calculations which use a discount rate of 10% we can see that Synthetic Resin has a higher NPV than Epoxy Resin. If we will consider a discount rate higher than 10%, the Epoxy Resin will generate a higher NPV than the Synthetic Resin. 9. In looking over the documentation prepared by the two project teams, it appears to you that the Synthetic Resin Technology would require extensive development before it could be implemented whereas the Epoxy Resin Technology is available off-the-shelf.” What impact might this have on your analysis? When we look at the payback period, we look at the initial outlay and cash flows. Synthetic resin is likely to incur additional costs due to its extensive development. This could mean that its initial outlay will be greater than expected, thus the figures that we have now may not be accurate once we started with the project. In that case, the payback period will be affected. From 2.5 years it can be longer to 3.61 years if the initial outflow is 1,500,000 and not 1,000,000. Since the epoxy resin is available off-the-shelf, its initial outlay maybe lower than the expected initial investment of 800,000. So the recovery period can be shorter than the expected period of 1.5 years. The Discount rate which is being used also effects the true value of the 2 projects. Epoxy being readily available anytime could imply that there is less risk involved. Also, at the current rate of 10%, this could mean that it's too high, which makes it okay for the company. On the other hand, the synthetic resin require extensive development. It means that it has a greater risk, and at only 10% can be seen to be too low. All in all, it can be concluded that the implementation of the 2 projects would greatly affect the analysis made.
